United States: A Taxonomy Of The Proposed Token Taxonomy Act

On December 20, 2018, a bipartisan pair of Congressmen, Warren Davidson (R-OH) and Darren Soto (D-FL), introduced bill H.R. 7356 to enact the Token Taxonomy Act (the "Act"). The Act proposes several amendments to federal securities and tax laws that are intended to clarify how cryptoassets should be treated thereunder. Below, we discuss the key provisions of the Act and their potential implications for cryptoasset market participants. Emphasis is placed on "potential" because, as we will discuss, the Act will likely require certain revisions, as well as substantial political support, before becoming effective law.

"Digital Tokens" Excluded from the Definition of a Security

The Act would amend Section 2(a)(1) of the Securities Act of 1933 (the "Securities Act") to explicitly exclude "digital tokens" from the definition of a "security." Under the Act, "digital token" is defined as a "digital unit" (i.e., a representation of economic, proprietary, or access rights that is stored in a computer-readable format) that:

(A) is created –

(i) in response to the verification or collection of proposed transactions;

(ii) pursuant to rules for the digital unit's creation and supply that cannot be altered by a single person or group of persons under common control; or

(iii) as an initial allocation of digital units that will otherwise be created in accordance with clause (i) or (ii);

(B) has a transaction history that –

(i) is recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through a mathematically verifiable process; and

(ii) after consensus is reached, cannot be materially altered by a single person or group of persons under common control;

(C) is capable of being traded or transferred between persons without an intermediate custodian; and

(D) is not a representation of a financial interest in a company, including an ownership or debt interest or revenue share.

This definition of digital token contains several noteworthy elements:

  • A pre-mine is fine. While the specified methods for a digital token's creation covers the coinbase transactions that allocate newly-created UTXOs to miners as block rewards, the provision in paragraph (A)(iii) also allows for pre-mines by insiders prior to a more widespread distribution of the digital tokens (so long as the requirements in paragraphs (A)(i) and (ii) are subsequently satisfied).
  • "Cannot" be altered? The requirement that a digital token's transaction history "cannot be materially altered by a single person or group of persons under common control," if read broadly enough, could cannibalize the entire exemption. Any public proof-of-work or proof-of-stake blockchain can, at least theoretically, by compromised by an actor or group of actors willing and able to commit sufficient resources to the task. Indeed, a number of public blockchains have fallen victim to 51% attacks to date, including Ethereum Classic.
  • A low bar for 'functionality.' Congressmen Davidson and Soto's press release states that the Act "clarifies that securities laws do not apply to companies that use blockchain once they reach their goal of becoming a functional network." The Act's requirement that a digital token be "capable of being traded or transferred without an intermediate custodian," however, sets quite a low bar for the notion of 'functionality.' The mere ability to transfer a cryptoasset peer-to-peer is a claim that can be made of any standard ERC-20 token.
  • If a cryptoasset represents a "financial interest in" a company, it is not a digital token. Importantly, paragraph (D) expressly carves out cryptoassets that represent a financial interest in a company, such as debt or equity, from qualifying as digital tokens within the meaning of the Act.

Certain Offerings of Digital Units Exempt from Section 5

In addition to excluding digital tokens from the definition of a security under the Securities Act, the Act would amend Section 4 of the Securities Act to create an exemption from Section 5 registration requirements for:

Transactions involving the development, offer, or sale of a digital unit if –

(A) the person developing, offering, or selling the digital unit has a reasonable and good faith belief that such digital unit is a digital token; and

(B) within ninety days following a written notification from the [SEC] to such person that such digital unit has been determined by the [SEC] to be a security, posts public notice of such notification and takes reasonable efforts to cease all sales and return all proceeds from any sales of such digital unit, excluding funds reasonably spent on the development of technology associated with the digital unit.

Thus, developers, offerors and sellers of cryptoassets may avoid violating Section 5 of the Securities Act (and suffering the consequences) even if they mistakenly believe their digital units satisfy the definition of a digital token – provided that they had a "reasonable and good faith belief" that the cryptoasset qualified as a digital token and, if the SEC notifies them of a determination to the contrary, they comply with the notice and refund provisions of paragraph (B).

Other Questions for the Act's Proponents

  • Should the digital token exclusion extend beyond the Securities Act and the Exchange Act? In conjunction with the Act's amendments to Section 2(a)(1) of the Securities Act, the Act would also exclude digital tokens (as defined in the Securities Act) from the definition of a "security" under Section 3(a)(10) of the Securities Exchange Act of 1934 (the "Exchange Act"). However, the Act fails to make parallel amendments to the definitions of a "security" contained in the Investment Company Act of 1940 (the "Investment Company Act") and the Investment Advisers Act of 1940 (the "Advisers Act").
  • Should the digital token exclusion be given preemptive effect? If not, the Act may be of limited efficacy, as digital tokens excluded from the definition of a security at the federal level may nevertheless be subject to regulation under state blue sky laws.

Expansion of Qualified Custodians and Good Control Locations

The Act would also amend the Exchange Act, the Investment Company Act, and the Advisers Act to provide that state-regulated trust companies offering custodial services for cryptoassets may satisfy the requirements to act as qualified custodians under the Investment Company Act and the Advisers Act, and constitute good control locations under Rule 15c3-3 of the Exchange Act. Specifically, the Act would: (1) expand the definition of "bank" under Section 3(a)(6)(C) of the Exchange Act to include a "trust company ... doing business under the laws of any State ... a substantial portion of the business of which consists of ... providing custodial services"; and (2) expand the definition of "bank" under the Investment Company Act and the Advisers Act to include a trust company which provides custodial services. These changes could freeze the SEC and FINRA out of a role in making judgments regarding the safety of client assets held by qualifying state-regulated custodians – leaving it to ports of convenience in states that have relaxed laws in this space – and thus may facilitate the ability of registered broker-dealers, investment advisers and investment companies to participate in the market for tokenized securities and other cryptoassets.

U.S. Federal Income Tax Laws

On the tax side, the Act would amend the Internal Revenue Code of 1986 (the "Code") by adding and changing several Code sections that could affect "virtual currency" traders, holders and sellers. Each of the amendments would be effective retroactively for sales or exchanges on or after January 1, 2017. This retroactive effective date could provide relief for traders and other sellers of qualifying cryptoassets who have failed to report certain of their transactions to the Internal Revenue Service and possibly provide those traders and sellers who have reported their transactions with an opportunity to claim a refund for certain taxes paid.

Specifically, the Act would do the following:

  • add a definition of "virtual currency" for relevant purposes of the Code. Virtual currency would be defined as "a digital representation of value that is used as a medium of exchange" and does not previously fall within the definition of currency under the Code;
  • add an exemption to the "like-kind exchange" provisions of Section 1031 of the Code for virtual currency, which would allow a like-kind exchange of virtual currency to be treated as a non-taxable exchange, similar to the current treatment of real property under Section 1031; .
  • provide a limited exclusion of gains of up to $600 from a sale or exchange of virtual currency from an individual's gross income, so long as the sale or exchange is not for cash or cash equivalents. The limited exclusion further would provide that all sales or exchanges which are part of the same transaction or a series of related transactions should be treated as one sale or exchange when determining excludability; and finally
  • add "virtual currency" to the exceptions list for the definition of "collectible" under Section 408(m) of the Code, which would provide that Individual Retirement Accounts that invest in virtual currencies will not have to treat such acquisitions as distributions.

These proposed changes in tax law would be significant and leave many open questions, including the broad definition of virtual currency itself and the application of Section 1031 to virtual currency.

Conclusion

Despite its shortcomings, the Act remains an important legislative initiative towards reducing regulatory friction for participants in the cryptoasset ecosystem. However, the Act is merely proposed and is not currently in effect. It's adoption would require political consensus developing behind an approach directly contradictory to the public stance taken by, among others, SEC Chairman Jay Clayton (and reinforced by a litany of SEC enforcement actions): "My view is that our rules have stood the test of time. I'm not going to change rules just to fit a new technology."

The Act appears poised to be reintroduced to Congress with revisions in the coming weeks. If the Act is appropriately revised and able to garner sufficient political support, it could meaningfully impact blockchain innovation in the United States.

A Taxonomy of the Proposed Token Taxonomy Act

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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